A blog by Francesco Papadia, providing a personal perspective on monetary policy developments drawing from an experience of 40 years in critical positions in central banking.

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Tuesday, 14 January 2014

Trust in Europe paid handsomely!

Over the first few days of January, the prices of sovereign bonds of peripheral €-area countries have recorded large increases. This has been matched by positive developments in market access and issuance. In some market commentaries these developments were noted with something of a surprised tone (for having made wrong forecasts about the demise of the €?). Such surprise is indeed surprising, since the posting of large gains by sovereign peripheral bonds is a persistent development that has brought large capital gains to those investors, included the ECB,which bought peripheral bonds when their prices were stressed.[1]

One rule not to be followed to make money is to invest systematically in assets that have had a good performance in the past: as it is written in "health warnings" in investment products "past performance is no indication of future performance". This obviously does not mean, however, that there are no cases of sustained out-performance: in some cases, some assets maintain a superior performance for a prolonged period of time.

I do not wish to enter here into a discussion of whether the financial market shows "weak market efficiency", whereby no rule based on past prices can deliver extra profits. I just want to carry out a brief ex-post analysis of return-performance of peripheral sovereign €-area bonds to see whether it tells, jointly with developments in economic fundamentals and institutional innovations, a consistent story.

This post is, in a way, the update of another post that Carlos De Sousa and I published on the Bruegel website (Where did the smart money go in 2012?) in which we showed that investing in €-area peripheral bonds was one of the best investments one could have done in 2012, with quite sizeable returns.

The same has been true again in 2013, as shown in the following chart: after the large gainsin 2012, Irish and Spanish bonds returned more than 10%, Italian bonds close to 8%. Somewhat symmetrically, return on core French and German bonds was slightly negative in 2013, as the safe haven flows were unwound.

Chart 1: Annual Total Return Index in selected €-area jurisdictions

Source: Markit; Data represents iBoxx indices for EUR sovereigns.

Also the story about economic fundamentals and institutional innovations was similar in 2013, but somewhat better, than the one of 2012.

On the economic front, the reabsorption of current account and budgetary deficits in the peripheral countries has been consolidating while competitiveness is being restored. The new, positive development is that the growth situation, while still anaemic and unsatisfactory, is not as grim as it was at the turn between 2012 and 2013. Unemployment is still very high and the debt situation (both public debt and external debt) is not improving as yet, but this is inevitable given the lagging character of these variables.

Table 1: Macroeconomic indicators in selected jurisdictions

Source: IMF WEO September 2013, Authors' calculations

On the institutional front, the biggest progress in the €-area has been on banking union, with the decisive progress on the single supervisor and on the resolution directive as well as the good steps forward on the single resolution mechanism.

All in all, the financial, economic and institutional developments are consistent with an overall story: the €-area is moving away, due to its dogged if inelegant and seemingly reluctant efforts and against all pessimistic forecasts, from the bad equilibrium which manifested itself in the Spring of 2010 to a good equilibrium.

Of course, the way to ruin the progress is to declare victory and relent on the efforts to complete the macroeconomic adjustment, to pursue institutional innovation and to establish the basis for more acceptable growth. In a way, writing this post, with its optimistic slant, I risked worsening the situation in the €-area, as I may invite complacency. Whoever writes on €-area matters and knows that Europe only moves under duress is torn between reflecting positive developments and keeping pressure on decision makers to act. I hope my readers are mature enough not to fall in the trap of taking recent positive developments as an excuse to stop, or worse undo, the repair work that has been made so far to remedy the limitations of the Maastricht construction.

*** Research assistance was provided by Mădălina Norocea

[1] In a previous post published for Bruegel, Has the European Central Bank transformed itself into a hedge fund? Carlos De Sousa and I estimated that the ECB had accumulated, until March 2013, 14 billion of capital gains on its purchases of Greek, Irish, Portuguese, Spanish and Italian bonds under the Securities Market Program (SMP). This figure must have significantly increased since the date in which we carried out the estimate given the further gains of peripheral bonds. In these times of budget restrictions a central bank making large profits must be something welcome to everybody, even those who disapproved of the SMP.